Scotland's Fiscal Outlook: The Scottish Government's Medium-Term Financial Strategy

4. Managing Fiscal Risks

Building on the analysis about both funding and spending, this chapter analyses the different sources of fiscal risk that need to be managed as well as the available fiscal tools to manage those risks.

4.1 Fiscal Risks

Section 4.1.1 sets out a detailed assessment of the structural and cyclical risks to funding and spending and includes: an estimation of the impact of each risk on the Scottish Budget; the current levers available to deal with each risk; and, the budget management tools available to the Scottish Government to support managing the risk.

The section considers risks on the funding and spending sides separately, as the levers and strategies to deal with such risks can be significantly different. The implementation of the fiscal powers devolved to Scotland are governed by the Fiscal Framework in place between the Scottish Government and the UK Government.^[24]

4.1.1 Structural and Cyclical Funding Risks

Table 14 : Summary of structural risks to the Funding Outlook

Risk	Estimated possible impact	Levers available to manage risk	Budget Management Strategy
Forecast error and reconciliation payments Errors in the budget forecasts are captured as reconciliation payments, which can either be positive or negative. This risk can be exacerbated by having two sets of forecasts, made by two separate forecasters at different times in the year and using different judgements about the economic outlook.	Negative reconciliations from Income Tax alone for the 2017-18 to 2019-20 budgets have cumulatively been worth over half a billion pounds across three years.	Resource Borrowing Powers Scotland Reserve Spending reprioritisation	The Scottish Government can use the limited powers available on resource borrowing and the Scotland Reserve to manage any negative reconciliation repayments that occur as a result of forecast error. However, historical negative reconciliations have exceeded the annual £300 million borrowing limit to deal with forecast error, and this is likely to occur more regularly in the future as the current borrowing and reserve powers are not protected in real terms. T here is a clear and reasonable case to revise the current borrowing and reserve powers, ensuring the Scottish Government has appropriate and sufficient budget management tools needed. The forthcoming review of the Fiscal Framework provides an opportunity to facilitate adequate risk management for forecast error over the medium-term.
Asymmetrical economic performance between Scotland and rUK. The Scottish Budget is directly exposed to the relative performance of the Scottish and rUK economies. For example, when devolved tax receipts per person grow quicker in Scotland than in the rUK, the Scottish budget improves and vice versa.	There is limited protection to the Scottish Budget when the Scottish economy or tax base performs more poorly than the rUK. Even relatively short periods of slower growth can add or subtract hundreds of millions of pounds from the Scottish Budget over time.	Long-term Economic, Social and Health Policy Spending reprioritisation	The Scottish Government has substantial powers to influence the long-term trajectory of the economy via policies in areas such as education, housing, transport and economic development. However, other areas critical to the economy remain reserved such as immigration and trade policy which constrains the Scottish Government's ability to manage longer-term demographic risks, including differential rates of population growth. The Scottish Government also has less control over medium-term sectoral risks, such as fluctuations in the performance of the oil and gas sector in Scotland, or the financial sector in London (see Annex A). The Scottish Government's ability to respond to short-term economic shocks, by smoothing out business cycle fluctuations in the short term, is further constrained by limits on discretionary resource borrowing and limits on the size of the Scottish Reserve. The Scottish Government invests in long-term policies, such as the newly published National Strategy for Economic Transformation, as well as in Education, Health Care, Fair work and other devolved areas to support Scotland's economic growth and performance relative to the rUK over the medium-term.
Compositional differences in the Scottish and rUK Tax bases. The current Block Grant Adjustment mechanism used for Devolved Income Tax and LBTT does not take into account the difference in the composition of the relative Scottish and rUK tax bases.	As shown in the December 2021 MTFS (Annex A), the cumulative impact of the compositional differences for Income Tax alone from 2017-18 to 2019-20 reduced funding to the Scottish Budget by £230 million.	Limited levers available	Levers to address a risk of this nature, such as the "By-Band" Block Grant Adjustment mechanism currently in operation in Wales, are a possible solution and should be considered as part of the Fiscal Framework Review.

Table 15: Summary of cyclical risks to the Funding Outlook

Risk	Estimated possible impact	Levers available to manage risk	Budget Management Strategy
Changes to UK Government spending There remains a continued risk of the Scottish facing significant in-year changes, resulting from changes to UK Government Fiscal Policy.	Adjustments to Barnett consequentials at any point in the financial year can change the Scottish funding outlook by hundreds of millions of pounds and can have a material impact on the funding outlook.	Scotland Reserve Spending reprioritisation	The Scottish Government can only use draw-downs and carry-forwards through the Scotland Reserve as well as reprioritising spending to manage this risk. It is not possible to use resource borrowing to manage this risk and the limits on the available powers (particularly the Scotland Reserve) are set well below the level of change that could occur to the funding outlook within the financial year.

4.1.2 Structural and Cyclical Spending Risks

Table 16 : Summary of risks to the Spending Outlook

Risk	Estimated possible impact	Levers available to manage risk	Budget Management Strategy
Spending pressure from increased demand from an ageing population The fiscal pressures of an ageing population are most apparent in our health and social care system and puts additional pressure on the NHS and social care over time.	An ageing population puts additional pressure on the NHS and Social Care over the medium to long term, and would also result in additional expenditure on social security payments, which is demand led. A decrease to the working population will impact both the funding and spending outlooks as this increased spend would need to be funded from a smaller active economy.	Spending reprioritisation Policy interventions	Policy interventions are required early in order to maintain the affordability of health care over the long term. In order to maintain funding growth for health and social care at comparatively high levels, spending reprioritisation could also be needed to manage this risk. It should also be noted that changes in the structure of the population will result in some areas of Scottish Government expenditure decreasing. Managing these shifts in expenditure will be a feature in coming years.
Demand-led nature of social security expenditure Social security expenditure is forecast to rise gradually to £6.5 billion by 2026-27, and any additional expenditure from changes to that estimate will have to be managed within the limits of the Scottish Government's existing fiscal powers. Forecast errors are expected to be larger for new payments as there is limited information for the SFC to produce their forecasts.	The SFC reported a 3% variation from their original forecast for 2020-21, which, if replicated in 2022-23, would amount to over £125 million, as the SFC's updated forecasts expect that social security expenditure will be almost £4.2 billion in 2022-23.	Spending reprioritisation Scotland Reserve Resource Borrowing	In Scotland, all benefits expenditure is funded through the overall Resource budget, as opposed to a dedicated AME (Annually Managed Expenditure) budget that would be better suited to funding demand-led expenditure on this scale, which is the case in England and Wales. Any additional investment will need to be funded entirely from the Scottish Budget envelope and will require prioritisation across other spending areas. The Fiscal Framework Review provides an opportunity to revisit the need for the powers and fiscal flexibilities necessary to manage unexpected increases in social security spending.
Divergence of demand-led expenditure from UK Government funding The Scottish Government is committed to building a new social security system with dignity, fairness and respect at its heart. Any additional devolved benefits, increases in payments or uptake, need to be funded out of the wider budget.	As a result of policy choices, such as delivering the Scottish Child Payment – which is not funded through any additional adjustments from the UK Government – and launching new benefits which replace the corresponding Department of Work and Pensions (DWP) benefits in Scotland there is expected to be a growing divergence between the level of funding received from the UK Government and the SFC's forecasts of devolved social security expenditure in Scotland.	Spending prioritisation	This additional investment will need to be funded entirely from the Scottish Budget envelope and will need to be prioritised relative to other areas of public spending

The Fiscal Framework broadly protects the Scottish funding outlook from economic shocks (such as higher levels of inflation) that affect the Scottish and rUK economies to a similar degree. For example, inflation can result in higher Income Tax revenue growth if the higher rate of inflation incentivises faster earnings growth in the economy and earnings growth turns out to be greater than any equivalent increase in the relevant tax thresholds. However, as long as the impact on the Scottish and rUK tax base is broadly equivalent in scale, then the Scottish funding position would be relatively unchanged as any boost to Scottish Tax revenues would be broadly offset by a similar increase in the corresponding tax Block Grant Adjustment.

However, the risk of higher levels of inflation is more likely to act as a risk to the stability of the spending outlook. For example, higher levels of inflation reduces the real term spending power of nominal cash envelopes across the forecast period. Given the minimal additional spending announcements made by the UK Government in the March Spring Statement, this means that the cash envelopes settled at the UK Spending Review in October 2021 (and the subsequent future Block Grant funding for the Scottish Government) cannot purchase the same quantity of goods and services as originally forecast.

4.1.3 Inflation Risks

Table 17: Summary of inflation risks

Risk	Estimated possible impact	Levers available to manage risk	Budget Management Strategy
Pay agreements are a key driver of public sector costs and spending exacerbated by inflationary pressures. Pay is a key driver of public expenditure and makes up over half of the Scottish resource budget Inflationary pressures will further exacerbate public sector pay pressures.	Table 13 models three scenarios based on assumptions around the pay award and future workforce growth to illustrate the possible impact on the Budget. For example, a pay deal that is 1% higher than the UK Government across the devolved public sector would add an additional £200 million into public spending	Resource Spending Review Public Sector Pay Policy	The RSR sets out a range of measures on pay and workforce. In addition the 2022-23 Pay Policy sets out the greater flexibilities available to employers who wish to seek a multi-year reform-based approach to pay. This aims to deliver better services for the public by driving further innovation, increasing value for money for Scottish taxpayers and ensuring the public sector is effectively equipped for the future.
Increased cost of living and inflationary pressures Fiscal impacts driven by wider economic factors – heightened and sustained inflation - will create additional pressure on the Scottish Budget and compound existing pressures from the pandemic.	Whilst it is difficult to quantify, there will be significant impacts on the purchasing power of budgets as well as demand for services and support.	Spending prioritisation	Inflation is already at a 40 year high, and expected to climb further. Higher fuel and food costs driven by the situation in Ukraine will exacerbate the cost of living crisis and disproportionately affect lower income households, making the Scottish Government's child poverty targets harder to achieve. Programmes will need to be targeted as far as possible to support low-income households and the Scottish Government will continue to do everything within our powers and fixed budgets to ensure our people, communities and businesses are supported as far as possible. M eeting child poverty targets will also require investment and the Resource Spending Review provides the overall spending envelopes in which this will happen.
Fiscal powers being eroded by inflation over time. Key borrowing powers and reserve limits within the Fiscal Framework are set in nominal cash values and hence are not protected in real terms from inflation or the growing size of the Scottish Budget / Tax base over time.	As illustrated in section 4.2, the real term effectiveness of the borrowing powers over 5 years from 2017-18 to 2022-23 could already have been eroded by as much as 24%.	Limited levers available	The Fiscal Framework review is an opportune moment to consider the challenges faced by fixed nominal limits on current borrowing and reserve powers. These powers do not adjust for the growth of the Scottish budget over recent years (including due to the pandemic response), and due to the lack of indexation their real term effectiveness deteriorates over time. At a minimum, these limits need to be indexed in some form. For example, limits on the Reserve could grow in line with size of the Scottish Budget.

4.2 Current levers for managing volatility and risk

The Fiscal Framework provides the Scottish Government with limited reserve and borrowing powers to manage volatility and risk.

The Scotland Reserve allows the Scottish Government to smooth spending within and between years, carry forward underspend and assist in the management of tax volatility, within set limits. Within its normal limits, the Scotland Reserve is capped in aggregate at £700 million, with an annual drawdown limit of £250 million for resource and £100 million for capital. However, the triggering of the 'Scotland-specific economic shock' provision in 2021-22, largely as a result of timing differences between the OBR's November 2020 and the SFC's January 2021 forecasts^[25], means that there is no drawdown limit for the Reserve in 2021-22 through to 2023-24.

The Scottish Government can borrow to support day-to-day (resource) spending only in very specific circumstances, primarily to address forecast error in relation to devolved tax receipts and social security spending and the corresponding BGAs. For example, where there is a shortfall forecast in tax receipts or an increase in demand-led social security spending; it cannot borrow to support discretionary resource spending.

The total limit for resource borrowing is £1.75 billion and the normal annual limit for forecast error is £300 million per year. Due to the triggering of the 'Scotland-specific economic shock' provision of the Fiscal Framework, the annual borrowing limit has been raised to £600 million until 2023-24.

As set out in the January 2021 and December 2021 MTFS, there is a growing body of evidence that the scale and magnitude of potential forecast error under the Fiscal Framework exceeds the level of flexibility provided by the existing borrowing powers.

Scottish Government analysis in the December 2021 MTFS outlined that there was between a 8% and 24% probability of total cumulative negative reconciliations across the various devolved social security benefits and tax revenues breaching the £300 million annual borrowing powers for forecast error.

This has already come to pass in the 2021-22 Budget when historical reconciliations exceeded the annual £300 million borrowing limit to deal with forecast error, and this is likely to occur more regularly in the future as the current borrowing and reserve powers are not protected in real terms.

This reflects the inclusion of the additional fully devolved taxes (LBTT and SLfT) and social security benefits with a BGA mechanism (although Income Tax remains by far the largest driver of the overall risk). SLfT revenues are also forecast to fall sharply in 2026-27 due to the implementation of the ban on landfilling of bio-degradable municipal waste which poses an additional issue for the Budget to manage.

The total limit for capital borrowing to support investment in infrastructure is £3 billion, with annual borrowing limited to £450 million.

The Scotland Reserve is the only mechanism for the Scottish Government to retain underspent funds for future years. The limitations on the use of the Reserve and the volatility relating to forecasts mean that it is neither feasible nor desirable for the Scottish Government to build up substantial balances in the Reserve. If the Scottish Government intentionally underspent its budget to carry forward funds to future years, there is a significant risk that the Reserve limit would be breached and therefore these funds would be returned to the UK Government and lost permanently.

A key constraint faced by the Scottish Government is that all of these limits are set in nominal terms even though the size of the Scottish economy, budget, devolved tax revenues and social security benefit expenditure rises over time. Consequently, over time the Scottish Government's current levers for managing volatility and risk are being effectively eroded in their real term capacity.

For example, since 2017-18 when the limits were initially implemented, they would have been around 14% larger by 2022-23 had they grown in line with inflation. Had they grown in line with the forecast cumulative size of devolved tax revenues they would have been around 18% higher and had they grown in line with the size of the total Scottish Government fiscal resource budget the limits would have been around 24% higher.

There are various arguments around how such limits could be indexed, however it is clear that even over a relatively short period of time, the real term effectiveness of the Scottish Government's levers to manage the risks and volatility within the Fiscal Framework has been eroded. The Fiscal Framework review is an opportune moment to index any nominal limits within the Fiscal Framework in real terms

In the meantime, whilst it is operating within these limitations, the Scottish Government uses the following guidelines when managing the budget.

4.2.1 Scotland Reserve policy

We will prioritise use of the Scotland Reserve to carry forward any forecast underspends for use in the subsequent financial year. This retains sufficient capacity in the reserve to be able to also carry forward any additional underspend that emerges later in the budget process (i.e., at provisional and final outturn stages) and mitigates the risk of funds being lost to the Scottish Government.

From 2017-18 to 2020-21, average reserves have been in excess of £350m, with a proportion of this being driven by consequentials provided later in the financial year to support COVID-19 actions. By prioritising use of the Reserve for this purpose, we ensure that sufficient capacity remains, so that, where excess tax receipts or additional underspends emerge from the Provisional Outturn and Final Outturn Processes, these can be added to the Scotland Reserve for use in future years.

4.2.2 Resource borrowing policy

The use of resource borrowing is complementary to the use of the Scotland Reserve. The Scottish Government must balance the need for flexibility against the additional costs of borrowing compared to the Reserve to find a solution that is most appropriate to the circumstances.

Resource borrowing powers will be used in a way that balances the principles of flexibility, stability and value for money, as set out in the 2019 Medium-Term Financial Strategy:

• Resource borrowing is an important tool to help achieve stable funding and spending trajectories, in order to ensure macroeconomic stability. Repayment terms would be as short as possible, to minimise servicing costs, subject to the need to smooth resource spending over time.
• In the context of the constraints outlined above, the scope for reductions in spending and/or use of any funds held in the Scotland Reserve would generally be considered first, before any decision is taken on resource borrowing.

The Scottish Government will assess all planned resource borrowing decisions to smooth the funding trajectory over five years. Scottish Government budgets have previously assumed full borrowing against known and/or forecast tax and social security reconciliations as the optimum approach to achieving this outcome.

To minimise volatility over the medium-term the equivalent analysis in Annex B now implies we should plan to borrow c. 50% of the full income tax reconciliation in 2023-24, in order to soften the impact of the even larger reconciliation in 2024-25.

This situation arises as a result of the current circumstances, namely:

• Scotland specific shock rules expiring in the year before the largest forecast reconciliation in 2024-25.
• The scale of the reconciliation in 2024-25.

As noted, other than to respond to changes in demand for social security spending, resource borrowing cannot be used to respond to emerging spending pressures, for example, to respond to the impacts of COVID-19.

Given the restrictions on resource borrowing under the existing Fiscal Framework, the only risks created by borrowing are those on future years' resource budgets resulting from borrowing repayments. It is therefore prudent to consider the medium-term impact on the Scottish Budget of reconciliations, borrowing and borrowing repayments in totality. Given the annual limits and short repayment periods, there is no risk of breaching the cumulative limit, and there is also no re-financing risk.

Conversely, there are considerable risks related to forecast error, economic shocks and funding outlooks, depending on UK Government decisions. The resource borrowing powers do not address these sufficiently. The annual cap of just £300 million against forecast errors is insufficient to fully mitigate large movements as evidenced with the situation in 2024-25. As the Scotland Specific Shock rules do not apply we are only able to borrow £300 million to offset the £817 million tax reconciliation. This also leaves no borrowing capacity to manage the risk of in-year forecasting movements.

The Fiscal Framework review is an opportune moment to consider the challenges faced by fixed nominal limits on current borrowing and reserve powers.

4.2.3 Capital borrowing policy

The two key considerations for the medium-term with respect to capital borrowing decisions are the headroom against the cumulative Fiscal Framework limits and affordability of ongoing borrowing repayments.

Capital borrowing powers will be used in a way that balances the principles of flexibility, stability, value for money and intergenerational fairness, alongside supporting the delivery of the NIM.

While the Scottish Government can borrow commercially or issue bonds for capital investment purposes, the National Loans Fund currently remains the preferred source of capital borrowing. Given the medium-term impact on resource costs, this remains the optimum compromise between value for money, resource cost impact and maximising the use of the Fiscal Framework limits.

The term-structure of borrowing will be chosen to strike the right balance between flexibility (requiring shorter-term lengths); value for money (requiring shorter-term lengths); stability (suggesting longer-term lengths); and intergenerational fairness (term length corresponds to asset life).

The previous policy set out in the December 2021 MTFS was to borrow between £250 million and £450 million annually over the period of the NIM to ensure that there is sufficient investment planned to support economic growth, and that investment increases overall year-on-year.

The Scottish Government also planned borrowing over the medium term to ensure that a minimum of £300m capital borrowing headroom will be available to be drawn down in the year following the period covered by the NIM (2026-27).

As we approach the half way point of the NIM we have reviewed the capital borrowing policy to ensure it continues to support the NIM while also providing long- term fiscal sustainability.

The analysis in Annex B shows that the Scottish Government can borrow £250 million annually over a 15 year tenor and sustain this policy (almost) indefinitely even within the existing cumulative limit of £3 billion imposed by the Fiscal Framework. Historic trends have shown there is a high likelihood of material movements on capital projects as well as additional capital consequentials arising in year.

We are therefore amending the policy to assume £450 million of annual funding will be available through borrowing, the Scotland Reserve and Barnett consequentials of which £250 million will initially be assumed to be capital borrowing. Where further capital borrowing is required to support funding the terms of any borrowing will be amended to balance the resource cost impact and longer term fiscal sustainability

All borrowing drawdown decisions will take into account the in-year budget management position, the interest rate environment and the impact over the five-year term versus the assumptions made in the Scottish Budget.

4.2.4 Tax policy

Scotland's first Framework for Tax^[26] was published in December 2021. It details how we approach tax policy and make decisions on tax, as well as setting out priorities for this Parliament. It provides a solid foundation for the design and delivery of tax policies that support our national outcomes and pursuit of a fairer and more prosperous Scotland.

The decision-making matrix in the Framework ensures that tax policy is developed in a consistent and coherent manner. The Framework also helps us to respond to the medium-term risks and opportunities for devolved taxes, so that sustainable revenues can be generated, supporting the delivery of priorities across the whole of government and the funding of public services in Scotland.

4.2.5 Resource Spending Review

Within the limitations of the current Fiscal Framework, controlling expenditure remains the primary lever to ensure the fiscal sustainability of Scotland's public finances.

As set out previously, the RSR sets out spending envelopes for the remainder of this parliamentary term which support the Government's ambitions and provide the parameters within which medium term plans can be developed. The RSR emphasises the importance of excellent public services, ensuring we achieve the best value possible from public spending for the Scottish public while living within our means.

4.2.6 The need for a robust and comprehensive review of the Fiscal Framework

The 2016 Fiscal Framework Agreement described arrangements for the devolution of further tax and social security powers to Scotland. The Scottish Government will continue to work within the framework, and work to improve on it, until such a time as the people of Scotland choose a different constitutional path.

The Fiscal Framework Agreement states that a review of the Fiscal Framework should be undertaken by the Scottish and UK Governments after Parliamentary elections in 2021. This will be informed by an independent report that will be presented to both governments in advance of the review commencing.

In October 2021, the Scottish and UK Governments agreed to commission an independent report focusing on the Block Grant Adjustments, including a call for stakeholder input, prior to a broader review of the Fiscal Framework. The arrangements for the independent report are subject to joint agreement between the Scottish and UK Governments. At the time of writing, the arrangements are being finalised and the report will be launched as soon as possible.

Both governments are working towards agreeing the scope for the Review, with the review aiming to begin in autumn 2022. Views from stakeholders, other than the two Governments, will be sought as part of the process.

As set out in the 2021 MTFS, as well as the Programme for Government in September 2021, the Scottish Government will use the Fiscal Framework review to push to strengthen the fiscal power of the Scottish Parliament including borrowing and reserve powers as outlined above, to allow more effective management of our key risks over the medium-term.

In the recent publication by the Independent Fiscal Commission for Northern Ireland^[27] the need for the right balance of risks and rewards, which devolution can bring, has been clearly demonstrated. They recommend that the devolved administrations have the appropriate suite of policy levers and are not unduly exposed to risks outside devolved policy maker's control, which is something we will be focusing on as part of the Fiscal Framework Review later this year.

The Scottish Government continues to seek a resolution on the outstanding dispute concerning the disproportionate impact of personal allowances increases on Scottish revenues, and the appropriate application of the spillover provision in the current Fiscal Framework Agreement. While the scale of the financial impact is disputed, both parties accept that a direct spillover effect arises from the UK Government's changes to the Personal Allowance and that the Scottish Government is due a transfer of funding. Longer-term issues relating to the spillover provisions should be considered in more detail as part of the forthcoming review of the Fiscal Framework.